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Heading for number yuan: the growth of RMB bonds

As the yuan, or renminbi (RMB/CNY), recently passed the Japanese yen to become the world’s fourth most-used payment currency, it’s worth taking stock of how far the RMB has come, its future growth path and what this means for investors.

23 Oct 2015

Angus Hui

RMB Fixed Income

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China and the Fed

In September, the US Federal Reserve (Fed) held interest rates steady and decided to delay lift-off, with Chair Janet Yellen citing, amongst other factors, the potential for ”further instability in global economic progress”. Markets took this to mean primarily China.

How times have changed. It was only in June 2013 when then-Fed Chair Ben Bernanke, following the “taper tantrum” (which refers to the sell off in stocks and bonds after the Fed first warned it was winding down its quantitative easing program) of the previous month, said that “strong global growth depends very much on the US growing at a reasonable rate1.”

It now seems Yellen’s recent comments were a tacit admission of the importance of China’s economy on, not only global growth, but also that of the US.

The 24-hour financial news cycle continues to focus on the slowdown in China’s juggernaut economy and the veracity of its economic growth data has also been questioned, given Chinese policymakers’ almost obsessive fixation on hitting their 7% GDP target.

Use of the RMB has surged as China’s economy globalises and its burgeoning middle class travel abroad.

But what about the currency? The recent brouhaha in the markets surrounding the devaluation of the RMB, triggering talk of a new currency war, has thrust it back into the spotlight.

Our view of this tends to be in the greater context of the currency’s increasing prominence over multiple years rather than days.

In this sense, the changes that it is undergoing look set to be as far-reaching as the economy’s transition from an investment-led to consumer-driven model of growth.

And the opportunities to tap this opening-up process will be manifold, for both passive and active investors.

Just as China’s economy can now not be ignored, neither can its currency. This will be particularly true for bond investors looking towards the world’s second-largest economy.

Charting the ascendancy

Use of the RMB has surged as China’s economy globalises and its burgeoning middle class travel abroad.

The ubiquity of the currency was highlighted by its rise to the fourth-most used currency in the world with 2.79% of global payments in August (by value) made in the so-called “redback”, according to payment services provider Swift.

It overtook the Japanese yen’s 2.76% share, with the RMB up from the 2.30% share it had in July.

Consistent with its phenomenal advance, as recently as January 2012 the RMB ranked number 20 with 0.25% but has since left the Hong Kong dollar, Swiss franc and Australian dollar, among others, in its wake.

Its ascendancy in trade finance settlement has been in lockstep with China’s rise as a global economic superpower – China is now the biggest export market for 43 countries; back in 1994 this number stood at just two2.

Uncertainty surrounding global growth provides further impetus to investors to take RMB bonds as a strategic long-term proposition.

Even so, this needs to be placed into context of the relative moves of the currency over the past few years. It remained stronger than it was a year ago, in trade-weighted terms, in the week following its devaluation.

Partially attributable to the PBoC’s fixing rate, which started to creep up after August, the RMB has also stabilised on account of the deployment of the country’s colossal US dollar reserves which, even after falling 12% since reaching a peak of $4 trillion, still stand at $3.51 trillion.

We view its recent devaluation as part of the broader reform of the currency and offshore RMB liquidity continues to remain stable.

Even after the PBoC’s surprise devaluation of the RMB 11 August, deposits in both Hong Kong and Taiwan – two key offshore trading centres for the currency – remained stable (see below) and there were no significant withdrawals during the month.

This scramble for a piece of the growing RMB payments pie has seen Hong Kong’s importance, as the primary destination as an offshore centre, diminish.

However, that has been a positive development. Multiple cities have announced deals to be offshore dealing centres, which should continue to propel the currency’s use and accessibility (see chart below).

Too big to ignore

It comes as no surprise that China’s burgeoning RMB bond market has been growing in prominence, in tandem with the currency.

The key questions are how investors can benefit from this transition and where we believe the best opportunities lie, in what is a fast-growing market.

As the chart below illustrates, the government bond market in China is the third-largest in the world, by market capitalisation. And it’s not only the government debt market that has been growing.

Corporates in China are starting to turn to the bond market to raise financing and this extends beyond the country’s renowned property sector.

Although property developers themselves are typically perceived to share similar credit profiles, this couldn’t be further from the truth.

Many have much stronger fundamentals and are an attractive proposition on a risk-adjusted basis. Any veritably diversified portfolio can no longer rule out RMB assets as part of its composition.

For investors, this is going to be a huge shift, albeit one that also offers opportunities.

For starters, monetary policy in China still offers scope for the PBoC to cut rates, unlike the policy conundrum of rock bottom rates and anaemic inflation central banks have to contend with in the West.

The latest rate cuts, announced in August, only saw the one-year lending rate slashed to 4.6% (see below).

Spreads over ultra-low yields found in the West is evident in that even RMB investment grade3 (IG) credits are yielding over 4% and could offer a greater degree of protection against any currency volatility.

Uncertain global conditions

It’s an oft-stated fact but China, along with a number of other Asian countries, will continue to benefit from lower oil and commodity prices.

This will lower input costs and also bolster China’s current account. In this sort of environment, we foresee longer duration bonds continuing to do well and expect high quality corporate issuers in China to outperform.

The effects of this collapse in commodity prices are positive for China’s current account balance while being negative for inflation (as we have seen in recent figures for both).

These are all bond-positive factors for investors and, in an environment where a strengthening US dollar is wreaking havoc on many emerging market currencies, the RMB has been relatively sheltered from this onslaught.

Uncertainty surrounding global growth provides further impetus to investors to take RMB bonds as a strategic long-term proposition.

The ongoing process of opening up China’s capital account will also see investors become more aware of the various benefits RMB bonds could offer for the long-term investor.

3. Investment grade bonds are bonds which are rated BBB- or higher by S&P and Fitch or Baa3 or higher by Moody's. These ratings are indicators of default risk on a particular bond issue -- with higher rating suggesting lower risk.↩

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